Libor consequences for asset managersBy Dr Arjuna Sittampalam, Research Associate with EDHEC-Risk Institute and Editor, Investment Management Review
The post-mortem on the much-publicised Libor rate rigging scandal is well underway in the world’s financial capitals. What is important to fund managers is how the false rates might have affected investors in the past, and what their future options are in terms of Libor or a possible alternative for contracts based on short-term interest rates.
Usage of Libor by asset managers is tiny compared with the overall volume of contracts where Libor figures, the most substantial proportion of which occur in the estimated $500trn derivatives market. Nevertheless, there are important contracts involving asset managers.
Pension funds with interest rate swaps linked to Libor will have benefited or lost according to which side of the contract they were on. Similar considerations apply to their purchasing loan agreements linked to Libor, packaged as asset-backed securities.
Floating rate notes comprise another area of interest, but possibly the most important of the potential impacts concern performance fee agreements where fund managers, largely hedge funds, base their performance fees on outperforming Libor. Absolute return funds also come into this category. These funds have been run not only for the retail public but also, for decades, for many institutional and corporate investors in the Middle East, Japan and elsewhere that have been seeking returns exceeding short-term interest rates and paying fees accordingly. Now that fund managers are getting into the bank lending business, Libor becomes relevant here too for some of the deals.
As to the actual impact of past gains or losses, most investment industry commentators, including pension funds, profess not to have the slightest idea. This is understandable, since to start with there is no precise estimate of how much rigging was actually done or for how long. The only certainty is that there was manipulation.
The authorities and banks are now vigorously looking for an alternative. One that is most often talked about is based on a repurchase rate (Repo) index. Two banks, UBS and Nomura, are among those testing the GCF Repo index published by the Depository Trust & Clearing Corporation, the group that clears and settles financial contracts. Unlike Libor, this is based on actual rates paid for the repurchase agreements that are a crucial source of short-term funding.
But it is feared that the Repo alternative might be more capable of being manipulated. Sharon Bowles, Chair of the Economic and Monetary Affairs Committee in the European Parliament, has announced her strong opposition. She feels that Repo markets are not always transparent and the idea has been attacked in the Capital Requirements Directive.
The US Treasury has suggested that it might issue floating rate notes that will fluctuate with the above Repo index. This would strengthen the case for the use of the index. When the volume of these notes grow, the demand for derivatives based on these would also increase, setting in motion a virtuous circle whereby the Repo index will give rise to a market with widespread acceptance.
One problem here is that US Treasury issues might, during times of panic, get distorted by demand from investors seeking safety.
Another possibility is to use overnight index swaps which track market expectations for central bank rates, but these are lower than Libor and would thus entail a subsidy to borrowers. The alternative is to adjust these OIS rates using credit default swap rates to reflect bank credit risk, but this involves the unsatisfactory route of setting cash interest rates through derivatives contracts.
Moving away from Libor involves huge costs. Are these worth the benefits of getting a more reliable and transparent benchmark for derivatives and other contracts? There is a huge practical problem as well. Millions of contracts will need to be re-negotiated individually and, since the parties on either side will be affected in opposite ways, either winning or losing, reaching agreements might be a nightmare. This factor alone could ensure Libor’s survival.
But authorities and others are muttering about making sure that Libor is based on actual transactions or that the banks are obliged to deal at a minimal level at the rate they quote, rather than providing an estimate that they do not actually deal at. The problem is that banks might be unwilling to do so and that the Libor market collapses. This danger is particularly acute at durations of six and 12 months, where transactions are sparse. The Bank of England, among others, is reported to be drawing up contingency plans for the possibility of such a collapse.
So what are fund managers to do? Many of them will possibly just muddle through, continuing with Libor, but others might individually fix some rate which offers stability. But, given the lack of a universal consensus on what this rate should be, every asset management house needs to consider an individual solution together with its client or counterparty.
- Investment Management Review, October 2012